A tax hike Republicans could cheer?

Ed MorrisseyPosted at 10:01 am on December 15, 2012

Actually, this is not so much a tax hike as a deduction cut. Peter Schweitzer proposed a “trillion dollar tax increase” that should find bipartisan appeal without disturbing capital investment or the middle class, and perhaps even encouraging capital to flow more to private markets. Why not end the tax exemption for municipal bonds — all munis, and not just those held by the top earners, as Obama proposes?

Common ground might be found in the $3.7 trillion municipal bond market. President Barack Obama has proposed limiting or ending the tax-exempt interest on municipal bonds for upper income Americans. Republicans would be wise to agree to Mr. Obama’s proposal and expand it to include the tax exemptions for all newly issued municipal bonds, regardless of income. According to the Congressional Joint Committee on Taxation, doing so would yield an estimated $124.4 billion over the next ten years.

Why would Republicans agree to eliminate a tax break? Simple: municipalities have become big spenders swimming in debt. Low interest rates and the current tax exemption make borrowing money cheap, thereby encouraging debt. The Federal Reserve reports that state and local government debt doubled over the last ten years, rising from $1.4 trillion in 2002 to $3 trillion in 2011. Shrink the incentive to bankroll big spending and you shrink the size of government—something most Republicans say they support.

But there’s another reason Democrats and Republicans can find common ground in ending tax breaks on municipal bonds: they’re rife with cronyism.

Some municipal bonds are issued for a city’s essential services, such as sewers and roadways, but many others go for non-essential, corporate enterprises. When local governments pick winners and losers, they force others to compete with government-funded cronies financed at lower rates than private companies enjoy—again, a theme Republicans rail against. That injects more corporate cash into local politics, something Democrats speak out against.

If state and local governments had to be more discriminating about which projects to fund with municipal bonds, perhaps they wouldn’t be so keen on green lighting bonds like the one the Poway United District, a subsidiary of the greater School District of San Diego, issued in 2011. Under the guise of a “capital appreciation bond,” the district approved a $105 million bond that will end up costing $982 million by 2051. The reason: payments on the debt are deferred 20 years, dramatically increasing the total cost of the borrowing. That means bondholders score a big return on their investment, but do so on the backs of taxpayers.

At least San Diego’s deal was done in the name of education; many others use taxpayer monies to fund sports stadiums. Indeed, Bloomberg News recently estimated that tax exemptions on interest paid by municipal bonds for sports structures rob roughly $146 million a year from the U.S. Treasury.

This is a part of the sports-stadium funding issue about which we rarely hear. The borrowing costs local and state taxpayers a bundle (for negligible economic results, as the same entertainment dollars would be spent elsewhere if sports teams moved), but the tax-free interest income means that taxpayers in other states essentially subsidize the deals, too.

There is a more fundamental reason to consider this tax increase, one that will probably mean an end to any Democratic support. Cities and states are drowning in debt, a crisis that has been overshadowed by the fiscal crises at the federal level. They borrow more and more money through the sale of these bonds, which come cheaper because of the tax-free income they produce for those who buy them. At some point, either these cities and states will have to budget appropriately in order to get themselves out of the red, or the federal government will have to bail them out. We could accelerate the pressure to do the former by making these munis a lot less attractive to investors — who might then decide that the private sector is a more worthwhile investment for their capital rather than the public sector.

Schweitzer makes the same argument, while noting that it won’t stop municipal borrowing. It might, however, slow down bond sales enough to force cities and states to start working on real reform. And at least taxpayers in flyover country won’t be paying for the interest on the latest sports cathedral on one of the coasts, nor the other way around, since my own state is the latest to foolishly decide to subsidize an NFL stadium. Los Angeles was rumored to be the home of the Vikings if the deal didn’t go through, but now Angelenos can take heart in the fact that even though they can’t buy a ticket to a Vikings game, they contribute to the stadium deal in some small manner anyway.